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Introducing the IvyVest Dynamic ETF Strategy

“I have $60,000 that has been building up in my checking account. What should I do with it?”

At its essence, that is the $60,000 question that we built the IvyVest premium service to answer. At the start, we set one rule: our "answer" was not going to be a guess, it was not going to be based on what we "think" will happen, and it was not going to be based on us having any kind of magical market intuition. We wanted to build a service that would answer that question in as objective of a way as possible, based entirely on data.

That of course meant a focus on the core investing fundamentals that have been proven countless times over the years: the importance of asset allocation, the benefits of staying diversified, and the huge long-term benefits of minimizing fees.

That is why our recommendations use the lowest-cost and most liquid ETFs that are on the market, and why we include up to ten asset classes in our model portfolios.

But to us, honestly answering the $60,000 question also meant taking one slight but important departure from the conventional wisdom.

The “textbook” answer to the question is that you should base your asset allocation entirely on your risk tolerance. If you are young and have a long time horizon and are able to withstand some volatility, you should own more stocks to take advantage of their (assumed) higher returns over time. On the other hand, if you are older and have a lower risk tolerance, you should own more safe assets like Treasury Bonds. This is the theory behind the popular retirement date line of funds that the mutual fund companies have been extensively peddling in recent years.

The problem with the traditional approach is that it totally ignores what price you are paying for an investment. At a basic level, it doesn't seem logical that you should own the very same portfolio today that you did five years ago. Because today, stocks are selling at basically twice the prices that they were five years ago. So if stocks are a good buy today, then they must have been a great buy five years ago (for more see Here's Where You Might Be Defying Common Sense With Your Investments).

It might be true that if you take the classic “buy and hold” approach to investing, that you will come out okay in the end. Markets, after all, tend to go up over time.

But the problem is that the "bumps" along the way can really hurt.

There is no guarantee that you will make money in stocks over even the next thirty years.

For instance if you had bought into the Japanese market at its peak almost 25 years ago, you would still be under water.

But can you really minimize these bumps and do better over time by paying attention to price? Can being a little bit "tactical" pay off?

Research suggests “yes.”

Academics have found at least two factors that can reliably assist in "market timing." And they both have the added benefit of making sense.

The first is momentum. Simply put, market prices do not fluctuate totally randomly. Instead, they move in trends that we call “bull” and “bear” markets. If the market has been going up lately, it is slightly more likely than not to keep going up. Similarly, if it has hit a rough patch, the odds slightly favor that things will remain rough (for more on momentum see "What Goes Up Continues to Go Up? A Beginner's Guide to Profitable Momentum Investing").

The second is valuation. Simply put, the long-term return that you can expect from buying stocks is greater when stocks are cheaper, and less when they are expensive.

Unfortunately, it is still not obvious how exactly to use these phenomenon to answer the question “how do I invest $60,000 today.” That is where our model comes in.

We went back to 1980 and tested several combinations of “rules” that we expected might work in determining portfolio composition. Our constraints were:

The portfolio should stay diversified at all times. We always want to own at least 8 of our 10 asset classes, and we always want to include aggressive assets as well as defensive ones, and assets that will do well in inflationary times as well as those that will hold up in a deflationary economic environment.

We do not want to have to trade more than four times a year on average (once about every quarter), since we think that it becomes expensive and difficult to maintain a portfolio that is much more “active” than that.

The rules should all make common sense. Anything we can’t explain to a reasonably intelligent investing novice is out.

After testing several different iterations, we settled on a set of rules that generated a 12.7% compounded annual growth rate (CAGR) from 1980 through 2012. Compared to an equivalent buy-and-hold benchmark, the model portfolio generated an additional 2.2% return (per year) over this period, while reducing the volatility of year-to-year swings by 20%, and reducing the maximum loss an investor faced (from peak to trough) by almost 50%. It also had a sharpe ratio (a measure of risk-adjusted performance) that was 57% higher (for more on the performance, see here).

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